Ethical bonds: a flight of fancy?

Fund managers are becoming more receptive to the possibilities and opportunities of socially responsible investing. As Hardeep Dhillon discovers, such an investment strategy can in many cases enhance, rather than jeopardise, returns

People who have ethical views and concerns about the environment or social issues have not always been pictured in a flattering light. They are often described as goofy green activists or tree-hugging hippies, albeit with a wholesome and moral nature.

Even in the capital markets, this rather dismissive view is hard to shrug off: socially responsible investors are still seen as the quirky citizens of the mainstream fund industry. Though the market for socially responsible investment (SRI) is predominantly in equities, it is slowly filtering into the realm of fixed income. But the process is gradual and SRI is still regarded a niche area.

Rory Sullivan, in the investor responsibility team at Insight Investment, argues that SRI is about encouraging higher standards of corporate governance and corporate responsibility in companies. “That is the aim but you won’t get that until you have a critical mass of investors that look systematically and critically at issues such as environmental performance, and factor these issues into their dialogue with companies and their investment decision-making process,” he says.

In the UK, church investment has used social, ethical and environmental screens since the 1920s, when the Methodist Church was the first to avoid ‘sin stocks’ in its investment policy. Charities have been slow to catch on, but legislation is prompting them – and the UK’s £800 billion pension fund industry – more along these lines.

The Pensions Act amendment of 2000 requires pension funds to disclose in their Statement of Investment Principles how they account for governance, social, ethical and environmental (GSEE) issues in their investment processes. But for some, this statement does not really carry much weight. Insight’s Sullivan says: “The reality is that very few fund managers have done anything about this at all.”

“This could merely be a statement that says, ‘we do not take account of these factors’ – therefore there is no obligation as such,” adds Morley Fund Management’s SRI analyst, Melissa Gamble.

Sullivan identifies two reasons for this lack of enthusiasm. First, fund managers are almost always rewarded solely on the basis of performance, with the consequence that there is little or no client incentive for fund managers to look at GSEE issues. Second, even where pension funds do see the importance of such issues, they can only act in their capacity as shareholders with formal voting rights. Bondholders lack these rights.

“It has been assumed that with this absence [of formal rights], a bond investor does not have influence. But the reality is that investors have significant influence in where they direct their capital,” says Insight’s Sullivan, arguing that the amendment to the Pensions Act should apply to all investments and not simply equities.

Klaas Smits, head of credit at Robeco Asset Management in Rotterdam, feels “it is far easier for equity holders to have an influence on a CEO than fixed income. Companies only need bondholders at certain points in the cycle.”

Change of mind

A shift in mentality is occurring as public awareness of social and environmental issues intensifies. Concerns about climate change, natural resource depletion, geopolitical risk, poverty and other pressures on the global economy are being whipped up by media coverage. These issues are becoming more relevant to business as they start to be translated into consumer preference, legislation, regulation and litigation, argues Morley’s Gamble.

“This is starting to drive institutional investor interest in this market, because analysis of SRI factors can lead to outperformance as we are looking at things that are underanalysed by mainstream investors,” she says.

Bryn Jones, portfolio manager at Rathbone, says that the investment community needs to further tap into this behavioural change. He argues that ethically run funds can provide clients with more than just good returns. “Our fund has protected investors from recent defaults: we could not invest in Parmalat and WorldCom due to poor corporate governance,” he says.

GSEE issues are also being promoted on an international level to increase awareness. A July 2004 report by a United Nations study group consisting of 12 global asset managers found links between GSEE awareness and financial performance. The group interviewed 11 global brokerage houses on what specific environmental and social criteria are likely to affect company competitiveness and reputation in seven industry sectors.

According to the results of the research, respondents agreed that environmental, social and corporate governance issues affect both short-term and long-term shareholder value. These findings would seem to support a positive relationship between the environmental and social awareness and financial performance of companies.

In October last year, a group of institutional investors launched the Enhanced Analytics Initiative. They agreed to allocate 5% of their broker commissions to the brokers who best integrate analysis of extra-financial issues and intangibles, such as corporate governance; human capital management; value creation or destruction during M&A; and global environmental challenges such as climate change.

The Institute of Business Ethics, an educational organisation, also believes that socially responsible companies have a better risk/return profile than others. And failure to embrace issues relating to the concepts of sustainable development and corporate responsibility can have a negative impact on financial performance.

Given that bonds are playing a more prominent part in investment portfolios, it seems unusual, maybe a bit short sighted, that SRI issues are not given more respect. “These issues can emerge over the lifetime of a credit. Ten years is a very long time for a corporate and so these themes still need to be identified, factored in and considered even if they do not affect credit ratings over the next three, six or nine months,” says Insight’s Sullivan.

One barrier that ethical investing needs to overcome is the view that as the SRI universe is far more limited than the overall bond universe, SRI investors increase the risk in their portfolio by reducing diversification. “The bigger the universe, the safer you are; as a fund manager, you need a degree of flexibility,” says a credit analyst at a US investment bank.

Advocates of ethical investing dismiss this view and state it is a misconception that SRI necessarily equates to poor performance and a trade-off between principles and investment returns. “Many think that funds underperform their benchmarks, but when you integrate extra-financial criteria in the definition of your investment universe, you are reducing the level of risk and you are enhancing the portfolio’s level of efficiency, so you get better returns in the medium to long term,” argues Xavier Desmadryl, SRI financial analysis manager at HSBC Asset Management in Paris.

Aegon Asset Management portfolio manager Philip Milburn adds: “You can invest in an ethical bond fund without compromising on performance and deliver no matter what the market conditions or constraints of fund.”

SRI investors are primarily looking for sustainability of financial returns. Some ethical and SRI funds do compete on a par with, or even outperform, many traditional mainstream funds. And their value-added is understanding the risks of companies’ impacts on the environment and society.

The size of the market

Figures on the size and breakdown of the total SRI market differ from one source to another. Estimates range from around €76 billion for institutional and €17 billion retail, according to consulting firm Mercer, to €336 billion for institutional and €12.1 billion for retail, according to 2003 figures published by Eurosif, the European Social Investment Forum. E.Capital Partners, a Milan-based advisory firm, cites €336 billion for institutional and €23.9 billion for retail. Others, like the fund information portal FERI, claim the SRI market for pan-European distributed funds grew to €14 billion in 2004 from €11 billion in 2003. Of this, bond assets accounted for over €3 billion in 2004, up from €2 billion in 2003.

This discrepancy in estimates is mainly because each research house has its own definition of what SRI criteria to use for assessment. Another reason is fund composition. In addition to the specific SRI funds, several ‘traditional’ funds have for some time employed SRI-type assessment criteria as part of their evaluation processes. The situation is complicated further when trying to judge how far extra-financial criteria are incorporated into an asset manager’s investment process.

The level of sophistication across Europe and size of local SRI bond markets are also a mixed bag. The UK only has three retail open-ended investment companies in the field: Rathbone Ethical Bond Fund, Aegon Ethical Income Fund and Morley Sustainable Future Corporate Bond Fund, totalling £166 million.

Bryn Jones, fund manager at Rathbone, states that performance of the Ethical Bond Fund has improved. “The returns and income of the fund, the Rathbone name, the low risk and the ethical ring-fencing all attract investors,” he says.

To help categorise some funds, the industry has come up with a colour-coding system, with dark green signifying the strictest criteria for inclusion and light green signifying more relaxed and flexible criteria. The Rathbone fund is dark green, only holds investment-grade paper and has experienced no defaults. “To be more defensive, the fund is able to hold triple-A bonds, cash, floaters, utilities, some agencies and triple-A securitised names,” says Jones.

Similarly Aegon’s is a dark green fund. Though it has the option to invest up to 10% in high yield, the remainder is investment grade. It has an average credit rating at mid-single-A and aims to outperform its peer group and be in the first quartile against the Lipper UK corporate bond sector on a rolling three-year basis.

“It is a vegan fund and the main criterion is avoidance, such as meat producers and retailers, nuclear, tobacco, pornography, intensive farming industries and oppressive regimes,” says Aegon’s Milburn.

The fund has holdings in financials, including triple-A wrapped securitised issues, is overweight insurance and TMT, underweight in supra-sovereigns, very underweight in industrials given Aegon’s ethical criteria, valuations, fundamentals and the threat of increasing M&A risk.

The Italian SRI market also has a strong retail focus. E.Capital Partners says that Italian assets under management stand at €2.2 billion in 2004, up from €1.5 billion the previous year. Socially responsible assets in insurance products rose to €1.5 billion from €509 million over the same time period. However the institutional market was only €175 million and expectations are that retail will continue to drive the SRI market in Italy this year. Greater involvement is expected from pension funds in 2006.

E.Capital is also an SRI market leader, having launched an ethical credit derivatives index in November 2004. The firm has since launched the first ever ethical collateralised debt obligation, marketed to investors in September. Company director Paolo Sardi says that interest in the CDO is coming not just from European investors but also US and Asia. The firm plans to launch a further five funds (bonds and balanced) before the summer.

“You need a track record and quality of criteria and SRI philosophies. Now more investors are realising the potential of SRI bonds as an investment where you can control the downside,” says Sardi.

Sanpaolo Asset Management was one of the first in Italy to launch an ethical bond fund in 1997, the €390 million obbligazionario etico, since supplemented by the €15 million obbligazionario venezia serenissima. Investment is restricted to investment grade issues, split European government bonds (50% euro and Danish krone); euro-, sterling- and dollar-denominated agency and supranationals (20%); and euro-denominated corporate bonds (30%, overweight financials and telecoms).

In France, the SRI bond market is also gaining momentum: 2004 volumes reached the €600 million–€900 million range and investors can choose products from HSBC AM, SRI asset manager IDEAM, Axa Investment Managers and BNP Paribas Asset Management.

BNPP AM has a total of €1 billion of SRI assets under management, including a bond fund of €200 million available to both retail and institutional investors with a performance target of 50–75bp above the Lehman Euro Aggregate. Interest is predominantly from clients that show a high degree of interest in corporate governance and sustainable development.

“We wanted to complement the existing range of our offerings and with the bond product, clients get the benefit of a more complete fundamental analysis without losing out on risk-adjusted performance,” says Eric Borremans, Paris-based head of sustainability research.

HSBC controls a pooled fund, the HSBC Euro obligation responsible fund catering for both retail and institutional clients and also manages mandates dedicated solely to institutional clients, such as pension funds and small retirement institutions. “We launched the fund for charity trusts that need to finance pension schemes. They feel comfortable with an SRI bias in their funds and are quite risk averse, afraid to move solely into equities,” explains Desmadryl from HSBC AM.

With its €19 million World Funds Development Debt fund, Axa IM takes an entirely different approach by targeting investment directly in micro-finance institutions that contribute to the sustainable development of economies on a local level. “We invest in short term instruments which are issued by micro-banks to sustain the development of local projects in very poor areas,” says Nadine Tremollieres, head of emerging fixed income in Paris.

Dexia AM launched its €257 million bond fund in July 2004 focussing on retail, predominantly in Belgium and Luxembourg. Helena Colle, SRI co-ordination at Dexia AM in Brussels, says that this is just the first stage of the asset manager’s SRI bond product offerings, as there are plans to approach institutional investors all over Europe in the fourth quarter of this year.

“We experienced a dramatic rise in interest in bond products in mid-2004 and this, combined with the quality filter of sustainable screening, enticed retail and private clients with a defensive investment profile to the product,” she says.

The German market for ethical bonds is set at just shy of €1.6 billion with 16 ethical bond funds, according to the Sustainable Business Institute in Oestrich-Winkel in Germany. Union Investment’s €137 million KCD Nachhaltig (sustainable) fund is 23% invested in sustainable corporates – favouring the telecoms sector and Italian and French subordinated financials.

“I see a lot of logic for lines, and though it may not be a major part of the mutual fund business, performance is still equal to other funds,” says Frank Hagenstein, head of corporate bonds at Union Investment in Frankfurt.

Robeco, seen as one of the leaders in SRI in Holland, launched a €30 million ethical CDO in October 2004, one that Klaas Smits says “helps the environment and the wallet”. The proceeds of the CDO will be invested in the CDS of firms that have a positive SRI rating, to protect against any default.

Jos Schreurs, structurer of the CDO, explains that domestic investors receive special tax treatment for sustainable investment. There is waiver on the 1.2% income tax and an additional tax credit of 1.3%, boosting the annual 4.1% coupon to a more attractive total return of 6.6%. They will only lose out if a name defaults, forcing the coupon to drop 95bp. “A green CDO has never been done before and investors want to invest in green assets,” says Schreurs.

Is the future bright?

Advocates are promoting the growth prospects of SRI investing. One benchmark for the market is the example of corporate governance, an issue that 10 years ago was not taken seriously but is now routinely considered.

“Though SRI is a niche market, in the longer term, some extra-financial criteria will be part of the mainstream process and be more important to some sectors than others,” says HSBC AM’s Desmadryl.

Morley cites British Energy as a prime example where heightened awareness of nuclear risks led to the asset manager selling out before the collapse – bonds as well as equities.

And though it is hard to gauge how far investors’ engagement of companies has had a tangible effect, pressure on companies to address and implement GSEE is increasing. “There has definitely been progress with an increasing number of companies managing GSEE issues properly. There is certainly recognition among companies that social and environmental issues are important,” says Insight’s Sullivan.

Competing strategies of analysis There is no one-size-fits-all approach to the analysis process in the SRI fund industry. “This reflects the principles in investment and the differing financial considerations that each fund has,” says Scott McAusland, media officer at Ethical Investment Research Services, better known as Eiris, in London. Alexander Barkawi, managing director, SAM Indexes in Zurich, agrees: “You have diversity and a range of offerings in any field of asset management. You need the same freedom on the sustainability side too. If the funds do a good job on performance and meet market demand, investors will reward them,” he says. Those that apply a screening process for selecting suitable investments for their funds include Rathbone, Robeco and Aegon, amongst others. All three have their own dedicated SRI teams that work independently of the main credit analysis process. “Chinese walls are in place and screening is at arm’s length,” says Philip Milburn, portfolio manager at Aegon. Aegon and Rathbone track the iBoxx sterling non-gilt index and both funds are left with about a third of the iBoxx names after screening. Aegon uses the Eiris criteria to evaluate companies. Rathbone excludes companies involved in armaments, environmental unsustainability, animal testing, tobacco, nuclear power, alcohol, pornography, gambling. Positive aspects include management of environmental impacts, human rights, equal opportunities in employment, community investment and provision of beneficial products and services. So for Rathbone, explains Bryn Jones, fund manager at the firm, issuing companies that demonstrate well-developed policies in at least one of the positive areas will be included in the fund as long as they are not involved in any areas of negative concern. Sources for the universe of investible names and analysis also differ. Union Investment and HSBC AM use the Dow Jones Sustainability World Index for their investment universe. HSBC AM also filters the names in the Lehman Euro Aggregate 500 MM, for corporate and government bonds, and uses Vigeo, an extra-financial rating agency, for selecting private issuers and the World Bank for analysis of sovereign issuers. BNP Paribas Asset Management uses financial research and advisory firm, Innovest and Vigeo for analysing companies’ performance on environmental and social issues, consultancy Deminor for corporate governance and ratings firm Oekom for country ratings. While Dexia Asset Management uses SiRi Company (Sustainable Investment Research International), an independent provider of SRI research and consulting services, for its screening services. Insight Investment, meanwhile, has a strong focus on engaging with companies it may invest in to encourage better GSEE standards, and also factoring these issues into its investment analysis, a similar strategy also employed by PGGM, the Dutch pension fund. The core philosophy of Morley’s approach to SRI is that combining corporate, social and investor interests will generate long-term sustainable benefits. “By attempting to identify key social, environmental and ethical factors and quantifying their impacts, we believe we can gain an information advantage that leads to the potential for consistent outperformance and the avoidance of downside risk,” Mark Gull, fixed-income fund manager at Morley. Morley also produces a “sustainability matrix” which rates companies on the exposure of their core business to social and environmental risk (rated A to E) and their management of social, environmental and governance matters (rated 1 to 5). Those companies rated C3 and above, excluding A5 and B5, are eligible for investment. “This tool helps us to identify which companies have the best quality management and are least exposed to risk. The tool is also used to define the investable universe,” says Melissa Gamble, Morley’s SRI analyst.

Setting the standard Just as the definition of ‘ethical’ differs from one person to another, so does the set of SRI criteria from institution to institution. But the question remains of whether the market needs a common set of guidelines and principles to follow. A widespread response from SRI advocates is that there is no real need for a pure industry standard as there is a general unanimity on what SRI should entail. “Each manager should define their own style so that there is a range of products and services available depending on clients’ needs and desires,” says Melissa Gamble, SRI analyst at Morley. But some market participants would welcome standardisation in specific areas. For example, Helena Colle, SRI co-ordination at Dexia AM, notes that not all screening agencies look at non-listed bond issuers, such as supranationals, Landesbanks or agencies. “It is important for us that they look at these credits, but the market is still evolving,” she says. Morley’s Gamble believes it would be useful for social and environmental information disclosed by companies to investors to be standardised in some fashion to allow better analysis and comparison of performance. Xavier Desmadryl, SRI financial analysis manager at HSBC Asset Management, adds that the UN’s Global Reporting Initiative is striving for a world standard on how to disclose social, corporate governance and environmental policy. “Once we have a common system of disclosure, then we will not be too far from a global standard,” he says.